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When prices of investment assets rise — assets like stocks or real estate — people generally feel this is a good thing. Such price increases are intuitively interpreted as representing an increase in intrinsic value — a perception of augmented wealth.
When the Dow Jones or S&P 500 indices rise, politicians crow with delight — claiming credit for wise economic policies.
At another level, we know that such price increases may signal a speculative bubble — but nevertheless, there is something optimistic and positive about such price movements.
The dead Efficient Market Hypothesis has left behind much harmful junk in financial space
On the other hand, the rise in price of consumer goods is generally met with dismay — a sign of inflation, not increased worth.
No one says the that the intrinsic value of sugar increases when sugar prices rise; or to put it another way, that sugar has somehow ‘performed well’ and that this higher price reflects recognition of this meritorious ‘performance’.
Theory Based on Popular Feeling
In 1965, in an article published in the Financial Analysts Journal, the following hypothesis was advanced:
An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.
In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future.
In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.
Young people, coming to Wall Street in the early 21st century, can gaze upon the ruins of many artifacts of the Efficient Market Hypothesis and wonder.
These words became known as the “Efficient Market Hypothesis” and, over the years, became the justification for index funds, mark-to-market accounting rules, Morningstar’s rating system of mutual funds, executive compensation based on stock prices, total return reporting rules of the Securities and Exchange Commission, and much, much more.
The article was written by a college student, Eugene Fama, who went on to become a famous economist, suggested at various times for the Nobel Prize.
Although never subjected to scientific scrutiny, and criticized from the beginning by more cautious economists, the Efficient Market Hypothesis had the backing of some with high academic credentials and connections and its message was pleasing to many on Wall Street who were engaged in the marketing of securities.
To the general public, the Efficient Market Hypothesis fit perfectly with the natural predisposition of most of us to assume that the increase in price of investment assets reflects an increase of intrinsic value. It was the perfect intersection between behavioral economics and the prejudices of classical economics.
To theoretical economists, the Efficient Market Hypothesis was soothing because it incorporated the concept of economic man, acting rationally, maximizing profits in self interest, while coming to the happy conclusion that free markets were indeed efficient, or at least heading in that direction.
The Efficient Market Hypothesis may be dead to economists, but it lives on in popular perception.
The ‘Death’ of the EMH
Today, the Efficient Market Hypothesis is largely discredited in professional circles, although the concept can still be seen in the intellectual carcasses of the various financial instruments that it had engendered, such as the index funds, and the myriad derivative products based on these non-managed investment vehicles.
Like many — or even most — aspects of economics, the Efficient Market Hypothesis was never subjected to rigorous scientific scrutiny, but its acceptance grew and waned gradually over the years, helped along with the opinions of many economists of greater or lesser fame, as explained in this Wikipedia article.
But what has kept the Efficient Market Hypothesis alive, even now after its virtual death, has been the common perception that links the rise in market value of investment assets to feelings of the possession of greater wealth. This perception is unlikely to go away.
Market Efficiency Better Defined
Perhaps the most egregious problem with the Efficient Market Hypothesis has been the concept of market price as representative of intrinsic value — in the singular.
Investors are no more uniform than this subway crowd.
As described in my article on Intrinsic Value, markets have many participants, each with quite distinct investment needs and constraints, resulting in millions of fully justifiable measures of intrinsic value.
Furthermore, whatever one’s perception of intrinsic value, investors also have changing needs for liquidity that force them, from time to time, to compromise their individual concepts of intrinsic values when pressed to exchange securities for cash.
Therefore, I would restate the concept of an efficient securities market as follows:
An efficient securities market is one in which market price approximates average perceptions of intrinsic value of the participants, weighted in accordance with the size of their holdings and discounted to reflect the weighted intensity of transitory individual needs for liquidity.
In other words, even in the perfect world of economic theory, market price is unlikely to be the same as the intrinsic value of a security for any particular investor.
Informational Barriers
In securities analysis, intrinsic value has long been defined as ‘value based on the facts’. Without knowledge of all available facts about a security, and without rational, careful evaluation of these facts, relative to the needs of a particular investor, there can be no knowledge of intrinsic value.
Informational barriers can as effectively impede the development of efficient securities markets as this high wall of concrete.
If no investors pay attention to the facts about the securities that they buy or sell, but only are aware of price, there can be no efficient market.
The Efficient Market Hypothesis is fallacious because its fundamental assumption that important current information would be almost freely available to all participants and that markets were mainly driven by competition among the many intelligent participants using these facts.
In fact, there are many barriers to the free flow of important facts to investors in today’s markets, such as:
- Time cost and complexity of information: Securities markets have become exceedingly complex and the volume of freely available information has expanded exponentially. See: The Economics of Security Analysis.
- The use of non-managed investment funds: Index funds and similar collective investment vehicles purposely eschew security analysis and attention to facts about particular securities. See: Index Funds and the EMH.
- The predominance of technical analysis: Chart-reading and related investment techniques purposely avoid attention to factual information about particular securities, other than price and trading volume trends.
It would be preposterous to contend that trading robots are making decisions based on intrinsic value of securities.
- The rise of robotic trading: High speed, automatic computerized trading based primarily on price and volume information, cannot result in investment decisions related to any concept of intrinsic value. See: Fat-Finger Thursday.
- Broken fiduciary chains: When investment decisions are made by fiduciaries that do not have substantive factual knowledge of the investment goals and needs of the final investors in the fiduciary chain, and when buy and sell decisions are made without such knowledge, investments based on any concept of intrinsic value are not possible. See: The Agency Problem.
- Manipulated markets: When market participants are allowed to engage in transactions for the purpose of manipulating prices, investment decisions are made not on the basis of interpreted intrinsic value, but rather in order to artificially set prices. The US market has been dominated by price manipulation since the practice was authorized by SEC Rule 10b-18. See: The Stock Buyback Era Evaluated.
- Incompetent investors: When investors do not have the knowledge to make informed investment decisions, or the inclination to spend time in the effort, or are too easily gulled into making unwise operations by unscrupulous intermediaries, markets must necessarily become inefficient.
There may be other informational barriers other than those listed above, but this list is sufficient to indicate that today’s investment markets have severe informational barriers.
The Inefficient Market Hypothesis
Having defined what is meant by ‘efficient markets’ and the concept of ‘informational barriers’, we may now proceed to propose an Inefficient Market Hypothesis, as follows:
Despite its supposed sophistication, Wall Street may actually be less efficient than this simple food market.
The efficiency of a securities market is inversely proportional to the impact of informational barriers on investment decisions.
Since the informational barriers listed above have dominated trading on stock markets in the United States for at least a generation, we may say that it is exceedingly unlikely that average stock prices — such as indicated by the Dow Jones or S&P 500 Index — are representative of the intrinsic value of securities on these markets.
This does not tell us whether prices are too high or too low — only that it is unlikely that prices reflect intrinsic value.
If markets are inefficient for long periods, prices are likely wander far from intrinsic value. There is no reason to believe that prices will have a tendency to ‘return to the norm’.
Consequences of Inefficient Markets
When securities markets are inefficient for extended periods — say a generation or more, as seem to be the case in the United States — market participants lose all notion of intrinsic value and market price takes its place.
People forget the original purpose of holding securities — obtaining a stream of income — and substitute instead the hope of selling these supposed ‘assets’ to someone else at some future date for a higher price, like baseball cards.
Expectation of future capital gains takes the place of current income.
Inefficient markets become completely unhinged from any rational interpretation of intrinsic value and market value is all that people have.
The insanity of inefficient markets will eventually be recognized, to the intense pain of millions.
Prices of equities may rise, as has occurred in the United States for two generations, and this long-term trend becomes, in itself, apparent ‘proof’ that market price and intrinsic value are the same.
Since the Efficient Market Hypothesis was advanced in 1965, we have seen a steady decline in dividend yields on common stocks, far below the yields of bonds of equivalent issuers.
Price-earnings ratios have soared, but no one seems to care.
Supposed ‘experts’ recommend stocks that don’t pay dividends and that are selling a thirty times earnings as being ‘cheap’. The only measure of value is market price and if a stock is lower in price than a year ago, it may in this regard seem to be ‘cheap’.
The Crash of 2008 was a major warning with regard to the inefficiency of Wall Street.
Nevertheless, within six months, prices were starting up again, although dividend yields were miserably low (compared to bond yields, the guideline in the days of Ben Graham).
No one spoke with any seriousness of actual intrinsic value. Instead, the guideposts seemed to be past market values.
But eventually, at some point, without an efficient market, common stocks become mere baseball cards.
Sooner or later, some Baby Boomer, pressed to pay his bills in retirement, will find that one can’t live off the dividends of common stock and that when everyone is trying to cash out their holdings at the same time, market prices plunge to levels that seemed inconceivable for generations.
But it will simply be the cost of allowing an inefficient market to flourish for so long.
How do you think it best to behave in an inefficient market?
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